Lecture outline- 8- Government Intervention in the market

We examined the behavior of the market in the absence of the government intervention
Govt. Govt.

Free Market System

Market System

The main reasons for policy intervention are:

To correct for market failure To achieve a more equitable distribution of income and wealth To improve the performance of the economy

Source:

Government Legislation and Regulation Parliament can pass laws that for example prohibit the sale of cigarettes to children, or ban smoking in the workplace. The laws of competition policy impose price controls in most of the main utilities such as telecommunications, electricity, gas and rail transport. Direct State Provision of Goods and Services Fiscal Policy Intervention (a) Indirect taxes (b) Subsidies to consumers (c) Tax relief: The government may offer financial assistance such as tax credits for business investment in research and development (d) A reduction in corporation tax (a tax on company profits) designed to promote new capital investment and extra employment 1. In a free market system government takes part in producing only Public Goods Public goods: Some ones Consumption will not deprive some one elses consumption. Private good: Some ones Consumption will deprive some one elses consumption. 2. In a mixed economic system government interferes in the economy in: a. participating in production b. Generating government revenue through imposing direct and indirect taxes. c. Providing subsidies to consumers and producers d. Protecting producers and consumers imposing price ceilings

Effects of direct tax on the market is minimal Effects of indirect tax on the market are substantial depending upon the elasticity of demand and supply. Case of Inelastic demand for the product: - Price will go up equivalent to tax rate D S1 S2 S0 t S - P1 -P0 P0 D t S1 S1 - P1 t S t S P1 - P0 P0 -

Consumer surplus and Producer surplus

Consumer surplus or consumers' surplus is the monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest price that they would be willing to pay. Producer surplus or producers' surplus is the amount

that producers benefit by selling at a market price that is higher than the least that they would be willing to sell for.

A subsidy is a payment by the government to suppliers that reduce their costs of production and encourages them to increase output. The effect of a government subsidy is to increase supply and (ceteris paribus) reduce the market equilibrium price. The subsidy causes the firm's supply curve to shift to the right. The amount spent on the subsidy is equal to the subsidy per unit multiplied by total output. Occasionally the government can offer a direct subsidy to the consumer which has the effect of boosting demand in a market. Demand elasticity and producer subsidy

P1 P0

S S1

P0 P1

S S1

Government intervention leads to worsen distribution of resources. 1. Distortion of the Market: Subsidies distort market prices - this can lead to a misallocation of resources many economists believe that the free-market mechanism works best. 2. Financial Cost: Subsidies can become expensive note the opportunity cost! 3. Who pays and who benefits?: The final cost of a subsidy usually falls on consumers (tax-payers) who themselves may have derived no benefit from the subsidy 4. Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need to restructure i.e. it delays much needed economic reforms 5. Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments

6. There are alternatives: It may be possible to achieve the objectives of subsidies by alternative means which have less distorting effects, for example by direct income support through the tax and benefit system
P2

Price ceilings

P0

Ceiling Price P1

When market price is too high and when it affects the majority of people in the system the government intervenes and set a ceiling price. Gasoline prices, milk food prices medical drugs etc. It leads to create queues. If there is a queue discipline then first come first serve system works. This also leads to black markets. Black market price will retain at P2. Price floor Because of this sense of inequity, or because of political pressure from farm groups, the government has had programs to aid farmers since the mid-1930s. One of these, called the price support program, is an example of a price floor. This is the farmers problem.

S
Price Floor P1 P0

D1 D S
Minimum wages.
Price Floor W1 Wm